JUNE 2008

Mergers and acquisitions expected to continue in paper industry
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The demand for paper is pushing the industry to focus on supply issues, such as capacity reduction. At the same time, Rock-Tenn Company sees an increased demand for recycled paper.

Expect more mergers and acquisitions in the containerboard and paper recycling industry. Most paper industry experts agree that the $6 billion purchase of Weyerhaeuser Co.’s packaging assets by International Paper is unlikely to be the last major deal.

International Paper, headquartered in Memphis, Tennessee, which expects to close the deal to buy the assets from Weyerhaeuser in the third quarter, is facing higher raw material and energy costs, along with the rest of the paper industry.

The entire industry is working to reduce capacity to cut costs, said Tom Runiewicz, an economist in Philadelphia with forecasting firm Global Insight, Inc.

The bigger issue is the recovery period for 2009.

The paper industry has no control of the price of raw materials. There is no control of the price of energy. Even with paper pulp, there is no control of the price of chemicals needed in the process. There is also only limited control of labor costs.

“But they do have control of their capacity and their overhead,” Runiewicz said.  

Cutting costs, therefore, is the best way to boost the bottom line. The paper industry is feverishly working to become more efficient by consolidating and closing mills, giving the industry pricing power and increasing capacity utilization rates.

“The big run up in prices that we have seen over the past couple of years is not due to big increases in demand. It is due to reduction in capacity and operating rates, providing pricing power by consolidating and reducing overhead,” Runiewicz said.

The top three North American containerboard makers controlled 27 percent of the market and the top six had 50 percent in the mid-1990’s, according to research by Longbow Securities LLC, a boutique investment firm in Independence, Ohio.

Following International Paper’s acquisition of Weyerhaeuser’s assets, the top two companies will control almost 50 percent of the North American market. The top five players will account for roughly 75 percent. The remaining 25 percent of the market will be split between smaller companies, each accounting for less than a 3 percent share.

As the bigger players get more of the market, it is harder for the smaller players to compete, Runiewicz said. “They are going to find it harder to compete on an efficiency basis. That is important when raw material price increases are being pushed on them.”

The current turmoil in the financial markets might make it harder for some deals in the paper industry. Runiewicz said acquisitions financed through debt might face problems, leaving deals for companies able to issue stock or use existing cash.

“If the companies have a good cash position then they may be all right. But if there is a fair amount of debt, then it is going to be tough. If you have a decent amount of cash flow, you are in a much better position to acquire or purchase somebody,” he said.

International Paper plans to finance its transaction through debt and other financing commitments. International Paper expects profit improvements of about $400 million annually and expects to achieve at least 40 percent of the improvement within 12 months of completing the deal. The remainder will be realized after three years.

Integrating Weyerhaeuser’s packaging assets into International Paper’s business fits into the company’s strategy to improve earnings and cash flow by strengthening existing businesses, chairman and chief executive officer John Faraci said.

“We expect the combined packaging business will generate stronger cash flow and higher EBITDA (earnings before interest, taxes, depreciation and amortization) margins than either stand alone business,” Faraci told investors in March.

Norcross, Georgia-based Rock-Tenn Co. completed its acquisition of Southern Container Corp. in March, making the company the eighth largest containerboard manufacturer in North America. John Stakel, vice president and treasurer, said the company tapped both bank lending and high-yield markets for $1.4 billion in financing.

“This financing was a testament to our strong operating results, cash flow and track record, and the tremendous quality of the assets that we bought,” Stakel said.

Some smaller companies that are not as well capitalized within the paper industry as Rock-Tenn, might find acquisitions more difficult, Stakel said. “The current credit market turmoil is impacting the ability of some companies to make acquisitions. Smaller companies may find it harder to tap into the broad sources of capital that are needed.”

Higher input costs are also having an impact, Stakel said. He said that increases in commodity prices have been well publicized. “There is typically a timing lag between increasing costs and your ability to pass through these cost increases,” he said.

Rock-Tenn is also seeing increased demand for recycled paper, Stakel said. Approximately 80 percent of the company’s paper content is from recycled paper.

Runiewicz, the economist with Global Insight, said that he expects demand for products from the paper industry to increase in the future, but not during this year.

“Overall we are looking for declines in demand for paperboard containers this year. That is a product of the overall recession that we are facing for 2008,” he said.

“The bigger issue is the recovery period for 2009.” Runiewicz said that he is not looking for a big recovery in 2009. “It may feel very slow and very sluggish,” he said.

The decline in demand is pushing the paper industry to focus on supply issues, such as reducing capacity. “As long as the supply side is maintained with these declines in demand, you see some flattening in prices, preventing prices from dropping,” he said.

The decline in the dollar has helped the paper industry as well. Runiewicz said the lower dollar has prevented increases in imports. “The lack of import penetration from foreign producers has helped out the United States paper industry quite a bit,” he said.